The British Pound starts the new week close to the multi-day highs reached against a number of currencies on Friday, with markets digesting news that the UK's sovereign debt was downgraded by ratings agency Fitch over the weekend.

Despite the broadly improved tone, the currency does remain highly volatile as is the case with most financial assets at the curent time, and we would therefore expect to see some movement both up and down as the day progresses.

Sterling might have gotten off to a better start were it not for the suprise news the UK was downgraded one notch from AA to AA- by Fitch after markets closed on Friday owing to the significant increase in fiscal spending announced by the Government in order to cushion the negative economic impact of the coronavirus outbreak, as well as due to the uncertainty regarding the post-Brexit trade relationship with the EU.

"GBP was the best performing currency, although it was weakening this morning after Fitch cut the country’s credit rating after the close Friday in New York, citing the weakening of public finances caused by the virus outbreak as well as the uncertainty about the post-Brexit trade relationship with the EU," says Marshall Gittler, Strategist at BD Swiss.

When downgrading the UK's sovereign debt rating, Fitch said they took into account, "the deep near-term damage to the UK economy caused by the coronavirus outbreak and the lingering uncertainty regarding the post-Brexit UK-EU trade relationship".

"This is the first downgrade of a sovereign on the back of the coronavirus and the increase in fiscal spending. We have had several reviews of Eurozone countries including France and Spain and neither has been downgraded on the back of the increase in fiscal stimulus," says Jens Peter Sørensen, Chief Analyst at Danske Bank.

Fitch forecast the UK’s economic output would drop nearly 4% in 2020 due to an economic downturn sparked by the coronavirus, "the downgrade reflects a significant weakening of the UK's public finances caused by the impact of the Covid-19 outbreak and a fiscal loosening stance that was instigated before the scale of the crisis became apparent," Fitch said.

The UK's Chancellor Rishi Sunak last Thursday announced further spending plans with a slew of support packages for the self employed.

The latest initiative takes the government's total support package of direct tax and spending measures to £119bn (5.3% of GDP), according to analysis from Capital Economics. Fitch estimate that the whole package will cost 4.4% of GDP in 2020.

Fitch's baseline projections show the government's deficit will increase by around 9% of GDP in 2021 from 2.1% of GDP in 2019.

Within this forecast, they estimate that the Coronavirus Job Retention scheme will cost 1.3% of GDP, assuming that 4.7 million employees will be supported over the three month duration of the scheme.

Above: Sterling's recovery against the Euro.

Agencies such as Fitch issue ratings on a country's bonds, reflecting how secure they believe those bonds to be. If a government issues small amounts of debt relative to the size of their economy, a ratings agency will rate them highly as they believe the government will comfortably service that debt.

The rating is meanwhile lowered if an agency believes a country will struggle to service a debt, thereby making the bonds it issues less attractive to investors. "The commensurate and necessary policy response to contain the COVID-19 outbreak will result in a sharp rise in general government deficit and debt ratios, leading to an acceleration in the deterioration of public finance metrics over the medium term," read a statement from Fitch detailing the decision to downgrade the UK's debt profile.

This matters as countries with lower ratings tend to have to compensate investors more for holding their debt.

For currency markets, debt downgrades can often trigger currency depreciations as international investors sell domestic domestic bonds in reaction to a debt downgrade. Sterling has however thus far shown little negative reaction to Fitch's decision, but the move nevertheless could have longer-term implications for the currency should UK bonds become increasingly unattractive to foreign investors.

"EUR/GBP has moved below 0.90 again, probably driven partly by the weaker USD. We think risks are still skewed towards a weaker GBP in the current environment and think it will move above 0.90 again soon," says Sørensen.

A move above in 0.90 in EUR/GBP translates into a move back below 1.11 in GBP/EUR.

Fitch says much will depend on how the UK approaches its public finances once the coronavirus crisis has passed, a consolidation of the UK's debt will go some way in improving its ratings profile. However, Fitch is not confident the UK government will be prepared to enter another round of austerity to rebuild the public finances.

"We fully recognise that timely and targeted policies can help reduce the risk of a more sustained loss of economic output. The likelihood that temporary stimulus measures are unwound will reflect policy choices and political developments. However, in our view, given the direction of public finances reflected in the March 2020 budget, it is unlikely that reducing public deficit and debt levels will be a priority for the UK government," said Fitch.

Rapid Recovery in Sterling can Hold

Fitch say the rapid response to the coronavirus crisis by the UK Treasury and the Bank of England should limit the second-round effects of the initial shock and should help growth to recover, assuming that the immediate health crisis subsides.

The agency adds the combined liquidity support measures which include GBP330 billion (15% of UK GDP) of loans and guarantees from the Treasury and the Bank of England are an important component of an effective near-term policy response, providing support to the ratings.

Ahead of the coronavirus crisis the government had already committed to additional investment spending to 3% of GDP, which would be its highest level for 65 years, and could further underpin the economy.

"Whether higher investment spending improves UK productivity and medium-term growth prospects would depend on how effectively such measures as large infrastructure projects are targeted," said Fitch.

The gains in Sterling over recent days form part of an ongoing recovery from the low points reached against a host of currencies earlier in the month; the UK currency has proven to be particularly sensitive to losses against the Euro, Dollar, Yen and Franc during period's of market weakness owing to declining investor sentiment stemming from the coronavirus outbreak.

However, a return of some investor confidence and market stability since central banks announced they would pump billions of dollars worth of extra liquidity into the global financial system, while governments announced measures to support their respective economies, appears to have stabilised the currency.

If markets should rally further, we could see Sterling's recovery extend.

"We do see a light at the end of the tunnel: there is still a reasonably strong argument for a v-shaped recovery, and policymakers are working hard to bring about that outcome. But, without medical breakthroughs of some kind, the next few weeks could be challenging for markets as we price in a deep global recession. We recommend that FX investors continue to lean cautious, with longs in traditional safe havens (USD, JPY, CHF) and a focus on relative value," says Zach Pandl at Goldman Sachs.

Sterling enters the new week with some relatively supportive near-term momentum, courtesy of a strong close to the previous week that surprised many in the foreign exchange market, that could deliver further gains over coming days. The UK currency rallied sharply against nearly all of the world's major currencies with the gains coming despite stock markets tanking: the FTSE 100, Dow Jones and Germany's Dax were all down over 2% as the week's recovery capitulates in impressive fashion.

The playbook for the current global market downturn goes that when markets are down, the Pound is down and vice versa when markets are going higher.

The Pound to Dollar exchange rate is quoted at 1.2394, the March low is at 1.1410.

The Pound-to-Euro exchange rate is quoted at 1.1180 at the time of writing, the March low is down at 1.0519.

"We continue to see upside potential for Sterling. Despite its relative liquidity, the pound was one of the G10 currencies most harshly punished by the dollar funding squeeze, possibly due to the UK’s large financial sector. As this issue seems to have been resolved, we expect Sterling to regain its lost ground by mid-year," says Gaétan Peroux, Strategist at UBS.

A surprising U.S. employment report that showed the U.S. economy actually added jobs over the course of May and news that the EU and UK remain committed to further trade negotiations served up a dose of optimism for Pound Sterling bulls to latch onto ahead of the weekend.

The British Pound is being tipped to retain a subdued tone ahead of the weekend, amidst reports that the ongoing final round of EU-UK trade negotiations will see both sides declare they remain far apart on key issues after talks close later on Friday.

The British Pound leapt 0.85% against the Euro and a host of other major currencies over the course of the past 24 hours, which makes for the largest daily gain since April 02 and potentially sets the UK currency up for further gains in what could prove to be a volatile week for the currency owing to another round of trade negotiations between the EU and UK.

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The news and information contained on this site is by no means investment advice. We intend to merely bring together and collate the latest views and news pertaining to the currency markets - subsequent decision making is done so independently of this website. All quoted exchange rates are indicative. We cannot guarantee 100% accuracy owing to the highly volatile and liquid nature of this market.